The winter of living dangerously

Chronically weak growth is Portugal’s gravest problem

AFTER Ireland and Greece, financial markets have lined up Portugal as the next domino to be toppled in the euro area's sovereign-debt crisis. A tense start to the year, as Portuguese bond yields rose, was followed by only a brief period of calm. Investors now seem less and less willing to give the government of José Sócrates the benefit of the doubt.

Since early February yields on Portuguese ten-year government bonds have been hitting euro-era highs above 7%. That level of borrowing cost is unsustainable for anything other than a short period; indeed, analysts at Barclays Capital think the threshold is 6%. Spreads between these distended borrowing costs and those on German bunds have widened to more than 4%; a year ago they were around 1%.

Portugal is vulnerable not because it is an identikit version of either Greece or Ireland, but because it shares some of the symptoms of both those afflicted economies. Portugal avoided the property-market frenzy that saddled Irish banks with bad debts too big for the state to bear on its own. But Portuguese banks nonetheless have lowish capital ratios and are among those addicted to liquidity support from the European Central Bank because they struggle to secure funding in international wholesale markets.

The resemblance to Greece is fiscal, though again Portugal's plight is less extreme. Government debt stood at 83% of national output at the end of 2010 compared with Greece's 140%. But Portugal's fiscal malaise is longstanding. As early as 2001 it became the first country to breach the 3%-of-GDP borrowing limit set by the European stability and growth pact. Since then it has run a string of deficits, peaking at 9.3% of GDP in 2009.

The government has set out plans to lower the budget deficit to 7.3% of GDP in 2010—a milestone it says has been passed—and 4.6% in 2011. Last year's improvement was helped by a manoeuvre in which Portugal Telecom's pension funds were transferred to the state. By contrast, this year's austerity measures, involving a fiscal tightening of 4% of GDP, are genuinely tough. Public-sector pay is being cut by 5% and taxes are being cranked up. But investors fret over whether the strong medicine will prove too much for a chronically weak economy, which may in turn prevent a viable fiscal turnaround.

Even before the recession GDP was barely crawling along, with growth averaging a miserly 0.7% a year over the past decade (see chart). The downturn itself was less serious than in the euro area as a whole—output fell by 2.5% in 2009—and there was a recovery in 2010. But the economy faltered in the final quarter of last year, when GDP fell by 0.3%. Portugal's central bank is forecasting a return to recession, with GDP falling by 1.3% in 2011.

What Portugal needs more than anything is an overhaul of its rigid labour market to foster greater competitiveness. Along with other Mediterranean countries, its economy lost ground to Germany's over the past decade and now needs to regain it. Reducing labour costs and boosting productivity is all the more important since Portugal is exposed to relatively low-tech areas of activity such as textiles that are vulnerable to competition from developing countries.

Reforms of that sort take time, however. Whether or not Portugal can avoid becoming the next domino to fall may no longer be in its hands. If European leaders fail to present credible plans to resolve the sovereign-debt crisis at their summit in March, that may well seal Portugal's fate.